The Dollar's Not-So-Scary Swoon

January 28, 2004

By Christopher Farrell The news wires carry the same headline almost every day: The dollar is falling against the euro. Indeed, the greenback is down some 35% compared to the single European currency over the past two years. The buck has also lost ground against the Japanese yen.

That's sowing concern around the world. The potential peril of a dollar crisis caused by America's twin federal budget and current-account deficits was a topic of heated discussion when the world's elite recently met in Davos, Switzerland (see BW Online, 1/26/04, "The Falling Dollar's World of Hurt"). The Bush Administration's apparent policy of allowing a weak currency in an election year, which bolsters the GOP's political fortunes in manufacturing states, is sure to raise hackles when the finance ministers of the world's seven largest industrial countries, the G-7, meet in Boca Raton, Fla., the first week of February.

The main fear is that investors will lose confidence in the dollar, sending U.S. interest rates skyrocketing, disrupting international trade, and risking a global recession. It's not hard to spin out a disaster scenario after the Congressional Budget Office's recent calculation that the federal budget deficit will hit a record $477 billion this year. The accumulated deficit over the next decade could total over $2 trillion, projects the nonpartisan think tank for Capitol Hill.

STILL BUYING AMERICAN. Yet the growing sense that a dollar crisis looms -- while it can't be dismissed -- may be exaggerated. After all, the Treasury market rallied after the CBO issued its gloomy budget forecast. The stock market barely skipped a beat as it rose to levels last reached before the terrorist attack of September 11. The Federal Reserve Board, which employs more economists than any other American institution, held monetary policy steady during its latest Federal Open Market Committee meeting on Jan. 28.

And far from losing confidence in the U.S., foreign investors continue to snap up American assets, including stocks, bonds, and companies -- despite the sell-off following the Fed's decision to gently remind investors that the central bank likely will need to raise rates sometime this year.

The problem with the dollar-disaster scenario is that looking at the greenback through the lens of the euro vastly overstates the decline. The euro's strength largely reflects the European Central Bank's tight monetary policy. The ECB's benchmark interest rate is twice the Fed's, and money sensitive to interest rate differentials is flowing to the Continent.

FURTHER OUT OF BALANCE. The rub is that America's record current-account deficit reflects a world that remains too dependent on the U.S. economy. The faster the U.S. expands, the more imbalanced trade and financial markets may become unless Europe and Japan begin embarcing policies to spur their domestic economic growth.

The dollar actually isn't down all that much compared to a more diverse basket of currencies that matter to American manufacturers and service companies. The Fed's broad trade-weighted dollar index is about 12% lower than its high of about a year ago. Even that drop may be overstated, according to a new report by the global economic and strategy research team at UBS Limited led by chief economist George Magnus.

The UBS researchers created a "current-account-weighted index." The current account captures America's economic relationship with the rest of the world, including trade in goods, services, and investment flows. The UBX index comprises those nations with the biggest impact on the current account: Canada, Mexico, the euro-zone, Japan, Britain, as well as a rough proxy for China (since some of the necessary data aren't available). The result? The dollar had actually risen in value into the end of 2003.

Now, any currency index is crude, and the numbers can be massaged different ways. Still, allowing for some drawbacks, it's clear that the dollar isn't a weak, let alone crisis-prone, currency. What investors should keep in mind is that the greenback's current perceived weakness says far more about politics and economics in Europe and to a lesser degree in Japan than it does about what's going on in the U.S. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online